The Fed Should Stop Buying Bonds

The Federal Reserve is currently buying USD85 billion a month of Treasury bonds and mortgage-backed securities. The coming policy meet is most likely to extend the bond purchase program into 2013. This article discusses the reasons for believing that the Fed should halt their bond purchase program.

Before I discuss the reasons for putting an end to the bond purchase program, it is important to understand the objective of the program. Only then, it can be concluded if the program is achieving its goals. Through bond purchases, the Fed primarily aims to keep borrowing cheaper in order to spur lending and investment. Also, higher lending and investments would directly impact the labor markets.

One of the best indicators of real economic activity is the money turnover in an economy. Invariably, economic activity is robust when money turnover is high and economic activity is sluggish when money turnover is low. I consider this indicator as critically important, because the Fed is looking at boosting lending and investment. If the money turnover is strong, the Fed's objective is achieved. However, sluggish money velocity would suggest failure of the current policy.

The charts below give the velocity of money stock [MZM], velocity of M1 money stock and the velocity of M2 money stock.

(click to enlarge)

(click to enlarge)

(click to enlarge)

Each of the measures indicates that money velocity or turnover has slumped since the beginning of the crisis, and the scenario has only worsened amidst policy actions by the Fed. Clearly, the Fed has failed to prop up real economic activity, and the bond purchase programs have just been an extended bailout for banks and financial institutions. Banks, on the other hand, are increasingly risk averse and have tightened lending standards. The excess reserves of depository institutions with the Fed back my argument on the futility of expansionary monetary policies and artificially low interest rates.

(click to enlarge)

Further, with real unemployment remaining high, consumers have exercised restraint on leveraged spending. I had also shown in one of my earlier articles that economic growth after the crisis has largely been as a result of necessary spending than luxury spending.

Therefore, it is time for the Fed to pause and introspect. Expansionary monetary policies need not be the best tool for economic recovery. This is especially true for an overleveraged economy or an economy witnessing the diminishing impact of debt on economic growth.

As mentioned earlier, the real unemployment rate also remains high despite the measures by the Fed to boost economic activity and labor markets. The U6 rate has improved marginally in the last few months. However, it still remains uncomfortably high at 14.4%. More than the bond buying program, clarity on fiscal cliff (especially related to tax) can help in propping up private sector growth and job creation.

(click to enlarge)

Besides these factors, it is also important to understand that interest rates will trend higher gradually in the long term. Keeping an economy addicted to artificially low interest rates can be counterproductive in the long term. Also, asset market distortion is a key risk when the Fed intends to suppress interest rates through bond purchase programs. With money increasingly flowing into commodities and other hard assets, inflation can be a concern in the medium to long term.

From an investment perspective, low interest rates and Fed balance sheet expansion are positive for risky asset classes. Therefore, from a long-term perspective, equities, commodities and precious metals should do exceedingly well. With the commitment to keep interest rates near-zero levels until 2015, the Fed has ensured that market participants generate higher ROI by investing in relatively risky asset classes.

My long-term investment recommendation would include the following ETFs and stocks:

SPDR S&P 500 ETF (NYSEARCA:SPY) - It has been proven that beating the index is not an easy task. Therefore, the strategy should be simple -- beat the index or invest in the index. From this perspective, SPY looks interesting. The ETF provides investment results that, before expenses, generally correspond to the price and yield performance of the S&P 500 Index.

SPDR Gold Shares ETF (NYSEARCA:GLD) - I maintain that view and investors can consider exposure to the hard asset for the long term. Expansionary monetary policies, artificially low interest rates and demand from Asian central banks will trigger long-term upside in the precious metal. The GLD ETF seeks to replicate the performance, net of expenses, of the price of gold bullion.

iShares Silver Trust ETF (NYSEARCA:SLV) - Very similar to the argument for gold, I am also bullish on silver for the long term. Investors can consider exposure to silver through the purchase of physical metal or the ETF, which seeks to reflect the price of silver owned by the trust, less the trust's expenses and liabilities.

BP Plc (NYSE:BP): Long-term exposure to oil exploration companies is a must if one is bullish on the energy sector. Geopolitical tensions, weaker currencies and demand from emerging markets will be the key growth drivers for energy stocks. I personally like BP, which gives me a dividend yield of 5.3%, besides looking promising for long-term capital appreciation. The company is an attractive long-term buy for several other reasons as well. It has an excellent and diversified asset base, presence across the value chain, and presence in alternative investment themes. Further, the TTM P/E is at an attractive level of 7.6. Overall, BP is well positioned to take advantage of the long-term appreciation in crude oil prices.

Johnson & Johnson (NYSE:JNJ): I like this highly diversified healthcare company, as it has product as well as regional diversification. Further, the sector JNJ caters to is not very prone to economic shocks. JNJ has been a good dividend payer in the past, with a dividend yield of 3.5%. In my opinion, the stock is excellent for a long-term portfolio. It also commands a higher rating than the U.S. sovereign rating.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

The bull market for India has just begun and there will be dozens of stocks that provide multi-fold returns over the next 5 years. With big reforms process expected to begin with the budget 2015-16, Economic Fanatic’s Monthly Market Commentary will provide investors with two well researched value stock picks. In addition, the monthly market commentary will update investors on any key economic event and its implication on the markets or specific sectors.

We only use your contact details to reply to your request for more information.We do not sell the personal contact data you submit to anyone else.

Thank you for your interest in Seeking Alpha PROWe look forward to contacting you shortly for a conversation.

Thank you for your interest in Seeking Alpha PRO

Our PRO subscription service was created for fund managers, and the cost of the product is
prohibitive for most individual investors.
PRO Alerts is our flagship product for individual investors who want to be faster
and smarter about their stocks. To learn more about it, click here.
If you are an investment professional with over $1M AUM and received this message
in error, click here and you will be contacted shortly.

Thank you for your interest in Seeking Alpha PROWe look forward to contacting you when we have an individual investor product ready!